A difficult time ahead for the Pakistani economy

Riots are exactly what the Pakistani economy does not need right now.

Adroit economic management coupled with generous assistance from the United States and other western countries helped pull the Pakistani economy from the brink of collapse in 2001, to a ‘star performer’ in 2005. But even before riots erupted across Pakistan in response to those controversial cartoons, there were already signs that its economy was in for some rough weather.

First, high prices of crude oil could drive inflation up over the estimated 8%, depressing domestic demand. Unless the government increases subsidies, higher energy costswill end up making Pakistani exports less competitive. But exports are an important source of foreign currency that Pakistan needs, both to service its foreign debt as well as to pay for its crude oil imports. The picture turned worse after Saudi Arabia’s recent decision to discontinue the special arrangement under which it sold oil to Pakistan at below market prices. Moreover, the raging insurgency in Balochistan has made domestic energy supplies risky.

Second, even after investing over $5 billion in upgrading plants and machinery, Pakistan’s textile industry has achieved mixed results. In 2005, Pakistan’s exports to the United States rose by 14% for textiles and 9% for apparel, but to the European Union, they fell by 10% and 11% respectively. Its textile exporters are sore that the EU has retained (although reduced) anti-dumping tariffs on bed-linen, and denied Pakistan the special market access that is made available to poorer countries like Bangladesh and Sri Lanka. Several Pakistani firms are considering moving their manufacturing operations to these countries attracted by the opportunity to lower costs. Given that textile exports contribute to 11% of its GDP and two-thirds of its exports, securing greater access to western markets is critical. Duty free access to the West remains elusive, not least because the focus of Pakistan-related diplomacy remains mutually centred around security issues.

Third, despite attempts by Gen Musharraf’s regime to paint Pakistan as an investor’s ‘paradise’, there have been renewed concerns about its domestic stability. Although attacks against Western interests declined last year (prior to the cartoon controversy), the insurgency in Balochistan began to spill over into Pakistani cities, including Karachi. Sectarian violence too made frequent and ugly appearances. The improvement in Pakistan’s investment climate caused by a reduction of the risk of war with India has not been matched by reduction in the risk of domestic conflict from various sources.

Managing these challenges got a lot tougher after the publication of those cartoons and the reaction it provoked in Pakistan. The riots disrupted business and destroyed property. But far more damage was done to Pakistan’s image when, in addition to indiscriminate rioting, multinationals and other foreign businesses were specifically targeted for looting and arson. Foreign investors cannot be blamed for not turning up for Musharraf’s invest-in-Pakistan party. After initially attempting to ride the wave of popular anger by conniving in the organisation of street protests, Musharraf’s regime is now trying to stop them. It may not succeed before more damage is done. Given the strategic nature of its investments in Balochistan, China is unlikely to be deterred from completing its projects. But other East Asian investors are likely to remain wary.

Securing greater access to Europe’s markets requires patient diplomacy. Denmark and Pakistan though, have justwithdrawn their ambassadors from each other’s capitals. Negotiations between Pakistan and the EU over textiles will be neither easy nor early. Pakistani ministers are still calling for boycott of European goods. A reciprocal boycott of Pakistani goods, were it ever to happen explicitly or resulting from worsened economic ties, will be very bad news for Pakistan. A combination of high oil prices and falling exports could mean that Prime Minister Shaukat Aziz will have to dig into the foreign reserves that Pakistan has built over the last few years. He won’t like that at all.